What does follow on capital from a VC really mean? Not much

05/22/2017By Sammy Abdullah, CFA

Being a small fund, one common question we get from entrepreneurs is whether we have follow on capital. Like most VC’s, we do have follow on and generally invest more than we originally did when we follow on (we’ve done it twice out of 12 investments), but like most VC’s, our follow on capital comes with strings. Here’s what VC don’t tell you about their follow on capital:

-You’ve got to earn it. No good investor throws good money after bad, so if your business is underperforming, do not expect a VC that has follow on capital to provide it. Generally, a VC has to underwrite your business from scratch when they consider making another investment in your company. This means going to committee and convincing their partners that they would do the investment even if they weren’t already invested.

-It won’t be the best deal. If you only turn to your existing VC for your new round and don’t test the general market, that’s an inside round and you’re unlikely to get a great deal. When VC have to compete, your valuation improves, so unless you absolutely have to do an inside round, you should go out to the wider market when it’s time to fundraise and at least see what you can get.

-Some VC need a 3rd party. Some VC can’t give you follow on capital unless a new investor comes in and prices the round. The reason: the VC needs a 3rd party to validate the investment to his own investors/LP’s.

All that said, follow on capital is valuable in two situations: i) when a new investor wants your current VC to invest in the new round so as to show that your current VC still believe in you; and ii) an inside round from current investors is your only option to stay alive. If either of these scenarios arise, it means your company is probably underperforming – a new investor will actually prefer to take as much of the round as possible versus letting current investors participate and inside rounds are only done when there is doubt about the ability of your company to attract new investors at a higher valuation. So, follow-on capital isn’t useless, but don’t over value it when evaluating VC’s.